Download Exchange rate policy forum: Bringing it all together:

Exchange rate policy forum: Bringing it all together:
where does this leave us, and where to from here? *
John McDermott
On 26 March the Reserve Bank and The Treasury hosted a forum on exchange rate issues for officials and other
invited participants to discuss a range of papers prepared by staff of the two institutions. In these concluding remarks,
Assistant Governor John McDermott offered some personal perspectives on the papers presented and the ongoing
issues around the exchange rate and economic performance. The papers presented at the forum are available at
http://www.rbnz.govt.nz/research_and_publications/seminars_and_workshops/Mar2013/programme.html
New Zealand’s exchange rate has been the focus of
investment needs by borrowing from the rest of the world.
much angst and debate recently. The fact that the average
The result is a capital account surplus. If foreign investors
New Zealand income has failed to converge with the
have any home bias in their investment decisions, then
rest of the advanced world over the past few decades,
the more foreign savings that are demanded, the higher
has also attracted attention, and has been a subtext to
the interest rate the domestic economy needs to pay.
the angst about the exchange rate. I agree that these are
But because the overall balance of payments is by
significant issues and those issues are indeed connected.
definition always zero, this capital account surplus requires
Angst about the exchange rate level, and perhaps the
a current account deficit. The exchange rate is the price
variability, crystallises in a view that if only monetary policy
that will yield a level of exports and imports to meet this
were run differently the problem would go away. But the
requirement and therefore the exchange rate will be more
hard won monetary policy lessons of the last quarter of a
appreciated. In this framework a lack of savings relative to
century demonstrate that we cannot generate sustainably
investment needs yields a prediction of domestic interest
more growth (in the real economy or in exports) by keeping
rates higher than the global average, a high (appreciated)
monetary policy unjustifiably loose. And any attempt to do
exchange rate and a persistent current account deficit.1
so would create future inflationary problems that would
This prediction matches the stylised features of the New
be costly (in terms of growth and employment) to resolve.
Zealand economy over the past 40 years. In passing it
So New Zealand’s economic circumstances pose some
is worth noting that in this stylised story monetary policy
serious challenges. Some things need to change. But the
played no role in generating such an outcome.
way that New Zealand’s monetary policy is conducted -
One of the worries often voiced is that New Zealand
quite conventional by advanced country standards – is not
is suffering from a surge in unwanted capital inflows
one of those things.
resulting in an overvalued exchange rate that in turn
To explore what might be the underlying cause of New
causes damage to exports and thus the economy’s growth
Zealand’s overvalued exchange rate let me start with an
potential. While there may be temporary surges from time
extremely stylised view of the economy, one which is easy
to time, what we would have expected to see – if this had
for everybody to understand.
been a persistent problem – is lower interest rates than in
The economy I am thinking about is one which is at full
the rest of the world and a high exchange rate.
employment and inflation is always on target so there is no
Of course, our economy is never at rest, so output
need for monetary policy. Suppose however, that savings
can cycle around its fully employed potential and inflation
are insufficient to fund the investment needs of this
economy (like New Zealand for the last 40 years). With
access to global capital markets, this economy can fund its
*
Erratum: this article replaces original Bulletin release.
Corrected to include text omitted in error..
1
Reserve Bank of New Zealand: Bulletin, Vol. 76, No. 2, June 2013
The trained reader will recognise this description as version
of the standard Keynesian IS-LM-BP model of the exchange
rate that can be found in a standard economic text book
such as Wickens, Michael (2008), Macroeconomic Theory: A
Dynamic General Equilibrium Approach, Princeton University
Press, Princeton.
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can cycle around its target. These cyclical dynamics can
how the insights of this analysis are incorporated into
generate volatility in the exchange rate. Moreover, given
policy advice. I expect the arguments will be debated – in
that exchange rates tend to move much faster than the
fact, I hope they will.
prices of goods and services, any disturbance to the
economy (whether trade related or not) can be reflected
in the exchange rate overshooting its long term fair value.
Such overshooting opens up the possibility of a
misallocation of resources between the traded and nontraded goods sectors. In addition, because the exchange
rate is taking more than its share of the adjustment it will
tend to be more volatile. Such volatility will add to the risks
and uncertainties of investing in the tradables sector and
thus reduce the incentives to invest.
The paper presented by Michael Reddell looks back
over history and takes a long term perspective of the
exchange rate issue. He points to the puzzle that over
a number of decades the real exchange rate has not
matched New Zealand’s relative productivity decline. This
stylised feature of the data seems all the more puzzling
given the far-reaching reforms New Zealand undertook in
the late 1980s and early 1990s.
While such a stylised framework provides a useful
starting point, it cannot really be used to diagnose New
Zealand’s economic conditions and offer policy options
because there are too many gaps. For example, this
framework provides no reason why savings would remain
low (relative to investment needs) over the long run.
Moreover, the framework is not rich enough to give any
insight into how the economy may be damaged from the
constellation of low savings, high interest rates, and high
exchange rates. For instance, story has no discussion of
how a high exchange rate can allocate resources away
from the tradables sector towards the non-tradable sector
and what that means for growth and productivity.
Reddell goes on to argue that not only has the
exchange rate not adjusted as might have been expected,
it has, if anything, been under upward pressure because of
the persistent real interest rate differential. This differential
reflects the fact that at any given interest rate (for example,
the “world interest rate”) there is a larger gap between
desired investment spending and the available national
savings than is typical abroad. As in the simple thought
experiment we started with, the underlying cause of the
long term problem is the saving-investment imbalance.
While many people have worried about the lack
of savings relative to other advanced countries, there
has been relatively little thought to the investment side.
The papers presented today fill many of the gaps left
by my stylised framework and put forward ideas that help
further our understanding of exchange rate issues in the
New Zealand context. Some elements of the story are
straightforward, and we can feel quite confident about
them. But there are many things we do not know with the
degree of certainty we would wish. Some of the puzzling
issues of New Zealand’s economic performance have
perplexed analysts here and abroad for a long time.
Reddell is something of an exception to this. He argues
it is the combination of New Zealand’s modest savings
and its quite large investment needs (associated with its
relatively rapid population growth) that largely resolves the
puzzle. The investment needed to provide infrastructure
and housing in a fast-growing population, in a country with
quite modest savings preferences, results in a need for
a high level of capital inflows. As above, the pressures
that generate these capital inflows yield higher interest
Policy choices cannot wait until researchers have
conclusively resolved all the puzzles. It is necessary for
both the Reserve Bank and Treasury to provide advice
even as we seek to increase our understanding. What
we have set out today is a process of thoughts and
judgements that lead authors to take the positions they
hold. After the forum we will need to reflect carefully on
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Overview of the day
rates and a higher average real exchange rate, which
crowds out business investment that would have lifted
New Zealand’s productive capital and allowed progress in
closing the income/productivity gaps.
The paper presented by Anne-Marie Brook starts
from the current state of long-term imbalances in the New
Zealand economy and examines what can be done going
Reserve Bank of New Zealand: Bulletin, Vol. 76, No. 2, June 2013
forward. The focus of this paper is on savings, with some
the scope within the flexible inflation targeting framework
seemingly radical ideas suggested.
to trade off volatility in the exchange rate against volatility
Unless we start confronting difficult and radical ideas,
in inflation. Four, introduce, or use more extensively, other
we will be stuck with the same problems we have had for
non-monetary policy stabilisation measures, such as:
the past 40 years. Brook puts forward some policy options
fiscal policy, macro-prudential tools, and supplementary
to boost private sector saving including tax changes, a
stabilisation instruments.3
range of different retirement income policy settings, and
policies that affect the housing market.
Some of the proposed stabilisation measures might
make a difference - and several are things I would
One option considered is the introduction of tax-
support, whether or not they made any difference to the
preferred saving vehicles to provide investors with options
amplitude/length of the exchange rate cycle. For example,
other than property. Specific options include: (i) reduce
we should avoid the situation New Zealand found itself
the tax rate on capital income, by extending the existing
in from 2005 to 2008, where increases in government
PIE regime; (ii) move towards a private save-as-you-go
spending exacerbated the imbalances already apparent
(SAYGO) pension system, which would involve pairing
in an overheated economy. And reviewing microeconomic
compulsory savings with means-testing of NZS; and (iii)
regulatory structures to help ensure that the economy can
strengthen the default policies that nudge individuals
respond more flexibly to shocks, (for example, removing
to save more (as KiwiSaver does). In addition, Brook
barriers to a responsive housing supply), are likely to make
considers a number of policies that would dampen house
good sense. Avoiding policy-induced swings in migration
price inflation, which may help to boost private saving.
is also likely to help (although many of the swings aren’t
Turning to cyclical issues Willy Chetwin, Tim Ng and
directly policy-induced at all). Reducing the cyclicality of
Daan Steenkamp examine real exchange rate volatility
domestic demand, the pressures that monetary policy
over the short term (periods up to one year) and the
has to lean against, is almost certainly desirable where
medium term (periods longer than one year). They find
possible - and is a case both our institutions have been
that the short-term volatility in New Zealand has been
making for decades. The use of macro-prudential tools,
generally greater than in most other advanced countries.
such as the new counter-cyclical capital buffer, may also
Significantly, they find that cyclical exchange rate volatility
help in this regard, although these instruments are more
has been large and that we have had longer-lasting cycles
likely to provide better resilience in financial crises than do
when compared to other countries.
much to dampen upswings.
Such volatility opens the possibility of economic harm.
Enzo Cassino and David Oxley examine the
Evidence of that harm is difficult to find, probably because
relationship between exchange rate movements and the
it is always difficult to see what otherwise could have
real economy. They survey a vast amount of theoretical
been under different circumstances. While we will never
and empirical literature for evidence on the relationship
know what the counterfactual could have been, it seems
between fluctuations in the exchange rate and its impact on
implausible to think a less volatile exchange rate would
the economy. They find the evidence is often ambiguous.
have led to the same economic outcomes we have today.
The relationship between changes in the exchange rate
To help mitigate this harm, Chetwin et al discuss
and adjustments in the economy does not follow any
various policy options that may be available. First, foreign
universal law, but depends on the nature of the shocks
exchange intervention might influence the short-term
exchange rate volatility, but it is unlikely to reduce mediumterm volatility. Second, improve the flexibility and efficiency
3
of the economy and financial system to reduce the reactivity
of the exchange rate to changing fundamentals. Third,
subject to inflation expectations remaining anchored, use
Reserve Bank of New Zealand: Bulletin, Vol. 76, No. 2, June 2013
These are not new ideas. The Reserve Bank and Treasury
looked into the issue in the joint Supplementary
Stabilisation Instruments Report in 2006 - undertaken
when domestic demand pressures appeared to be pushing
the exchange rate to uncomfortable levels. The Reserve
Bank also provided advice on this issue to the Finance and
Expenditure Committee inquiry in 2007. Papers at the joint
Treasury/Reserve Bank/VUW conference in 2011 touched
on this issue.
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affecting the economy. Thus, while it is possible that any
exchange rate overvaluation may have a negative impact
Conclusion
The papers presented in this forum cover a great
on the economy, the existing empirical evidence does not
deal of ground and confirm the widespread sense in the
allow them to reach a conclusive view.
public debate that there are some exchange rate issues
Concerns about the exchange rate often give rise
that matter for reversing New Zealand’s poor long-term
to questions about alternative regimes. The possible
economic performance. Much of the public debate so
alternative regimes – floating, fixed or hybrid – are
far has centred on what monetary policy can do about
explored in the paper by Willy Chetwin and Anella Munro.
an overvalued currency. But the papers presented today
They consider the trade-offs an economy faces when
demonstrate that the issue is much bigger than monetary
deciding on its combination of exchange rate, monetary
policy.
policy and capital account policies.
As much as we would like it otherwise, the
We all may like to have independent monetary policy
overwhelming evidence is that monetary policy just cannot
to control inflation, a stable and predictable exchange
make a sustained difference to the real exchange rate. At
rate, and free access to global capital. Unfortunately, the
the margin, monetary policy and foreign exchange rate
famous “impossible trinity” of international finance tells us
intervention can perhaps take out the worst of the peaks
we can only have two of the three. Advanced economies
and the troughs of the cycle in exchange rates.
outside the euro area have tended to choose open capital
There are non-monetary policies that could be used
accounts, independent monetary policy for inflation
to reduce the long-run average of the real exchange
control, and have foregone control over the exchange
rate. For example, fiscal policy could be geared towards
rate. New Zealand has made a similar choice. If New
increasing public savings (in the process building fiscal
Zealand was to move in a different direction and pursue
buffers and expanding NZSF contributions). Policy options
greater exchange rate control, that would imply less use
to increase private savings include: taxing income from
of monetary policy for stabilising domestic conditions such
savings at a lower rate than from labour income; automatic
as inflation and output, or a less-open capital account and
enrolment of all workers into the KiwiSaver scheme; or
probably require the holding of a larger stock of foreign
even making KiwiSaver mandatory. Those responsible
currency reserves.
for such non-monetary policies might well give serious
The paper presented by Richard Sullivan provides a
consideration to some of these policies. In addition,
history of New Zealand’s monetary and exchange rate
improving our understanding of New Zealand’s desired
regimes since the break-up of the Bretton Woods system
savings and investments would be useful, especially
in the early 1970s. Sullivan focuses on the real exchange
since the interaction between our low savings and heavy
rate and how varying regimes affected its performance
investment in housing has undermined New Zealand’s
over the last 40 years. In large part, most exchange
economic performance.
rate regimes New Zealand has tried – and we have tried
A number of non-monetary measures that might be
many—have seen large real exchange rate variation.
used to moderate the exchange rate cycle have also
Sullivan finds that the mean, range, and variance of the
been looked at over the course of the day, including: fiscal
real exchange rate prior to, and since the introduction
policy, macro-prudential policy, and various supplementary
of the flexible inflation targeting regime, are virtually
stabilisation instruments. Further work on the likely impact
identical. Moreover, he also finds that whatever exchange
of these measures would be useful. Irrespective of
rate system is used, fluctuations in the real exchange rate
whether they can change the real exchange rate much,
have been driven by traditional economic drivers such as
some of these measures would be good to implement in
the terms of trade, relative cyclical economic performance
their own right.
and inflation outcomes.
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Reserve Bank of New Zealand: Bulletin, Vol. 76, No. 2, June 2013